An Upside-Down Approach to Retirement Planning

Most online retirement calculators ask the same question: how much do you expect your investments to grow per year? Eight percent? Six percent? Isn’t there a checkbox for “who knows?”

The problem with this approach isn’t just that nobody knows off the top of their head what they expect to earn on their investments. It’s that they can’t know—especially if they’re heavily invested in the stock market. What if you live today based on the assumption that your stocks will return 10% annually, but when you hit retirement age, it turns out they’ve only returned 6%? You’ll have to postpone retirement—if you’re lucky enough to keep your job.

Economist Laurence Kotlikoff, a professor at Boston University and author of Spend ’Til the End, thinks he has a better way. What if we treat the stock market portion of our portfolio as a gamble? Live now as if our stocks are going to fail spectacularly; this standard of living is your “income floor.” Then, in retirement, we can be pleasantly surprised. Even if our stocks do poorly, we get a little boost in retirement. If they do well, we get to live it up.

Kotlikoff calls it Upside Investing, and as of today, he’s built the feature into his popular retirement calculator, ESPlanner Basic (the software costs $60 for the Upside Investing feature; you can try the rest for free). He recently ran the program on his own portfolio. “I was amazed,” he says. “I’d been waiting to see this myself, and I was amazed to see, by putting less in the market, you get a much bigger floor, and the upside loss is not so great.”

Hit the floor

Here’s how Upside Investing works. You give the software all of the information you’d share with any retirement calculator: your income, existing savings, expected social security benefits, and so on. (You can also say that you expect major inflation, or a tax increase, or other bad mojo.) You also tell it how much you’re putting into the stock market and when you want to start selling those stocks and buying safe assets (inflation-protected treasury bonds).

Then the program calculates. And calculates and calculates. You sit there for several minutes while the computer runs millions of scenarios. (I told Kotlikoff the program was slow, and he was mildly offended; given how much work it’s doing, he says, it’s actually amazingly fast.) Finally, you’re offered a prescription: here’s how much you can spend per year between now and retirement. Then, in retirement, you can continue spending at least that much, plus a bonus that depends on the performance of your stocks.

This, Kotlikoff argues, fits the psychology of investors better than the traditional “spend as if your stocks are going to do well” method. “Large fractions of the population have these preferences which we economists refer to as habit formation preferences,” he says. That means you get accustomed to a certain lifestyle and get very upset when your living standard drops. “So you want to plan to establish kind of a floor to your living standard, and you’re happy to have it go up.”

Retirement upside the head

Enough theory. I logged into ESPlanner and ran some scenarios. Kotlikoff was right…for me, anyway. Here’s what I learned:

1. By lowering my allocation to equities, I can raise my living standard today at the cost of slightly less upside in retirement. Whether I’m 50% in equities or 10%, my retirement looks much the same: I’ll get at least today’s living standard, and probably somewhat better.

2. This is true, in part, because I’m making generous assumptions about the solvency of Social Security and my wife’s pension, which together will, theoretically, cover most of our needs in retirement. Even with more pessimistic assumptions, however, ESPlanner tells me there’s little reason for me to own more than, say, 20% equities. (I also tried running it with the assumption that my wife’s pension would be converted to a 401(k), and this still didn’t have much of an effect.)

3. If you’re in the middle of your career, do not have a pension, and have a modest amount in your 401(k), Upside Investing will tell you to start saving an enormous amount of money, and you will want to go get drunk.

For Kotlikoff, whose own portfolio took a big dive in 2008, Upside Investing is all about convincing people they don’t need the stock market as much as they think they do. “Before we start putting people into risky securities,” he says, “we should show them exactly what life would be like, and here’s the upside and here’s the downside.”

“I think he’s targeting kind of a small group of individuals,” says Jeremy Vohwinkle, a chartered retirement planning counselor who writes the Generation X Finance blog. “If you’ve already got money saved, you’ve done well thus far, it’s time to kind of ratchet things down and lock in some steady gains.”

This is financial planning conventional wisdom, Vohwinkle points out: your investments should get more conservative with age. But, he warns, “younger people could read these kind of articles and think, oh, well maybe I should sell my stock and just put it into TIPS or put it into some kind of fixed asset — and that’s just not going to work, because they haven’t saved up enough to where that 2% real return is going to make any kind of difference.”

Improve your living standard while sitting on your butt

What if I were one of Vohwinkle’s normal human clients, just getting started on retirement saving with a few thousand bucks in an IRA? Taking an Upside Investing approach would kneecap my current standard of living.

“The stock markets are really a wild ride,” says Kotlikoff. “We can’t fantasize about those realities. These are tough tradeoffs.”

But there are other ways to raise your living standard besides taking on more risk and crossing your fingers. Kotlikoff reels of a bunch of ideas: compare Roth and traditional IRAs; take Social Security earlier or later; adjust your levels of retirement and regular savings; pay down your mortgage; open a 529 college savings plan. (He points out, naturally, that ESPlanner can help you determine which strategies offer the biggest payoff, and that there’s a list of free case studies on his website.) “I think almost everybody can get their living standard up from 5% to 20% just by playing with our software,” he says.

Are you down on the upside?

This is not meant to be a love letter to a particular piece of software. Upside Investing is about human psychology, not bloodless economic analysis, and it’s an approach you can take even without buying the software. I plead guilty to those “habit formation preferences”: I’d be pleased if my living standard went up in retirement, but devastated if it went down.

Not everybody shares this conservative outlook—or has the means to do so. “We don’t know whether it’s 20% or 80% of the people out there” who would benefit from the upside approach, says Kotlikoff.

If you think you might be in that group, however, it’s worth the price to give it a try. (Yes, there’s a money-back guarantee.) “His calculator’s definitely going to give you a pretty good ballpark of where you stand and how feasible that plan’s going to be,” says Vohwinkle. In other words, ESPlanner can tell you whether you’ve saved enough to ratchet down your risk without having to live on Top Ramen.

Matthew Amster-Burton is a personal finance columnist at Mint.com. Find him on Twitter @Mint_Mamster.